outline 2013
TRANSCRIPT
March 2013
1
Clear Goals and Objectives
1 3 52 4 6 7
LDI and Overlay Strategies
Liquid Market Strategies
Liquid and Semi Liquid Credit Strategies
Illiquid Credit Strategies
Illiquid Market Strategies
Ongoing Monitoring
SEVEN STEPS
Redington designs, develops and delivers investment strategies to help pension funds and their sponsors close the funding gap with the minimum level of risk. We take our clients through a rigorous 7 Steps to Full Funding™, which begins with laying out clear goals and objectives and assigning tasks and responsibilities. The second step is building an LDI Hub, or putting in place a risk management toolkit. Steps 3-6 involve crafting the right investment strategy to fit the need using a full range of tools and bearing in mind the goals and constraints of the scheme. Finally, ongoing high quality monitoring is essential to continually track progress against the original objectives and guide smart and nimble changes of course.
Introduction 2
Smoothing Over The Truth 3
The Genius Of The AND Versus The Tyranny Of The OR 4
Importance Of Carry To LDI Strategies 2 5
Estimating The Equity Risk Premium 3 6
Equity Replacement Strategies 3 7
Risk Parity Rationale 3 8
Commercial Real Estate Debt 5 9
Monitoring Progress On The Run 7 10
Dynamic Risk Management In Practice 1-7 11
A Step Change in “Money Safe” Defined Contributions Saving 12
Further Information and Disclaimer 13
Contents
O U T L I N E March 2013Contents
STEP PAGE
Introduction
Gurjit DehlVice President, Education & Research
Welcome to the second edition of Outline, Redington’s quarterly collection of thought-pieces designed to help institutional investors make smarter and more informed decisions.
The next ten pages feature articles on the key topics and opportunities we think institutional investors should be considering as they aim to meet their goals, including our thoughts on the DWP’s smoothing consultation, alternatives to the Equity Risk Premium, risk-controlled strategies for DB and DC and an example of dynamic risk management in practice.
We hope you find the articles interesting and helpful as you consider how best to manage the risk-adjusted return of your portfolios.
For more information on any the topics, please do get in touch.
Kind regards,
Gurjit Dehl
OUT LINE
2O U T L I N E March 2013Introduction
We believe that the DWP’s recent call for evidence on “whether to smooth asset and liabilities in scheme funding valuations” versus marking-to-market goes to the heart of the pension risk management debate.
To value a pension liability using smoothed assumptions is akin to diagnosing a patient based on the average of the last few years of symptoms; it is highly unlikely to produce the correct diagnosis or an effective cure.
A practical perspectiveThe most important argument against smoothing is that it may lead to further under-funding of pension schemes, as sponsors seek to reduce contributions based on a smoothed valuation, and contribution rates become de-coupled from market-based funding positions. This may be particularly detrimental in an employer insolvency situation, as having a contribution schedule that is unrelated to market movements increases the likelihood of the scheme being underfunded on the PPF’s valuation basis.
Smoothing could encourage “gaming” of the system, either in choosing to adopt (or not) smoothing in the first instance, or when moving between smoothed/unsmoothed valuation bases (if this were permissible) to select the most favourable basis. Smoothing may also create confusion as schemes could report funding positions that move contrarily to the accounting valuation or to what may be expected based on market observations.
One driver of the consultation is the Autumn Statement in which the Chancellor said that “the Government is determined to ensure that defined-benefit pensions regulation does not act as a brake on investment and growth”. However, DB pension liabilities represent an enormous liability to UK businesses, very substantially protected in law. It is unavoidable that these liabilities affect investment and growth, with or without changes to pension regulation. There are two main issues arising from DB pension schemes that may act to deter investment into companies. First, a pension deficit represents company debt; smoothing would simply mean that investors look to other sources, such as the accounting valuation, for an estimate of the debt. Second, where a deficit exists, it usually requires cash deficit repair contributions. “Smoothing” of cash contributions can be achieved by amending the deficit repair schedule, which is already feasible under the current system.
Importantly, it should be possible for trustees and their sponsoring employers to produce an investment strategy that runs an appropriate degree of risk (and hence an appropriate contribution volatility) versus the strength of the employer. If schemes are instead able to reduce contribution volatility by smoothing, there is less incentive to reduce risk economically e.g. to “hedge” the liabilities. Worse, smoothing could potentially introduce additional volatility into the funding positions of well-hedged schemes, driving schemes to adopt riskier investment strategies than they otherwise would. It would be wrong to penalise schemes that have acted prudently to manage their investment risk, in favour of schemes that have not.
Smoothing Over The Truth
Karen HeavenVice President, Investment Consulting
3O U T L I N E March 2013Overview
The Genius Of The AND Versus The Tyranny Of The OR
Current debate over Defined Benefit (DB) pensions continues to capture the attention of the public and press.
Recent years have dealt lethal blows to the industry, and now, in 2013, despite the introduction of auto-enrolment and the consultation of the Department for Work and Pensions about reassessing the valuation methodology, we face two serious challenges:
1 Repairing DB pension deficits and improving member security without harming the commercial future of our corporates.
2 Growing and securing an adequate and sustainable income in retirement for those not in a DB pension.
As an industry, I believe we are on the whole trapped in what Jim Collins describes in his book “Built to Last – Successful habits of visionary companies” as the Tyranny of the OR. Collins defines the tyranny of the OR as the rational view that cannot easily accept paradox, that cannot live with two seemingly contradictory forces or ideas at the same time. The tyranny of the OR makes people believe that things must be either A or B, but not both:
- High cost pensions or less secure pensions
- Investment returns or low risk
- Risk or low return (See the Pension Regulator’s Trustee Tool Kit, which assumes risk and return are linear)
In order to fix the pensions problem, we must instead adopt what Jim Collins and Jerry Porras call the Genius of the AND: the ability to embrace both extremes. We can reduce risk of investment underperformance against liabilities AND maintain expected return in order to reach full funding.
We must flout the calls of naysayers and shoot for this ideal.
Redington’s 7 Step Framework to Full Funding™ allows pension funds to embrace the Genius of the AND, helping stakeholders to accomplish with trustees and sponsors that which should not, according to traditional standards, be possible. The 7 step framework encourages vision and creativity and yet is grounded in robust, accountable and disciplined business principles. It’s not about sitting around dreaming, it’s about planning and strategising for the best case scenario, in a world in which the best case scenario is allowed to exist, even within the harsh economic environment that surrounds us.
No doubt there is a great challenge in altering our collective mindset; embracing new ideas is not an easy task for any collective of professionals. But we must switch, and switch quickly.
“ The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.
One should, for example, be able to see that things are hopeless and yet be determined to make them otherwise.”
F. Scott Fitzgerald, The Crack-Up
In the pursuit of pensions and business goals, a dualistic third approach of generating investment outperformance and managing risk is ever present. The habit of making either/or decisions leads to thinking in the realm of Black OR White and Risk OR Return. If important decisions are made through the tyrannical lens of OR, vision is inhibited, and progress is therefore hampered. Without dreaming up a goal that could be, it will never be.
Robert GardnerFounder & Co-CEO
4O U T L I N E March 2013Overview
Importance Of Carry To LDI Strategies
It may seem counterintuitive, but it is possible to invest in low yielding assets and generate attractive excess returns.
Consider, for example, Japanese Government Bonds (JGBs). Since 2002, 10 year JGBs have yielded a measly 1.22% p.a., but their total returns exceeded yields by almost 1.00% p.a. with a volatility of just 3.88%. This equated to a return of LIBOR +1.86% per year and in risk adjusted terms, this made JGBs very attractive assets indeed. If, for example, they were leveraged such that their volatility was 10%, then JGBs would have delivered a mouth-watering LIBOR +5.06% p.a. While some of their excess return resulted from further, small declines in interest rates, much of it was generated by what is known as carry, as JPY rates were already low and stayed low over this period.
In a fixed income portfolio, carry is defined as the mark-to-market that results, assuming that nothing changes in the market except for the passage of time. Carry is a function of the shape of the interest rate curve. When the curve is upwardly sloping, as it is currently, the market is implying that interest rates are expected to rise in the future. If the expected rises occur and forward rates are realised, then carry will be zero. If the expected rises, on the other hand, do not materialise and forward rates are not realised, then carry will result and depending on the steepness of the curve, it can be significant.
Within the context of UK LDI, an interesting question to ask is whether carry can have the same impact here as it has in Japan over the past ten years. Our current situation certainly shares similarities; banks are deleveraging, economic growth is weak, and gilt yields are “low”. And, not surprisingly, carry in the GBP interest rate markets is similarly high.
In today’s market environment, most pension scheme liabilities will grow due to carry, even if interest rates do not fall further. Using the current interest rate curve, a typical pension scheme liability profile would grow on the order of 2.5% per year as a result of carry. If the current interest rate environment persists for the next three years, this means that liabilities would have grown by almost 8% simply through the passage of time (service accrual and benefit disbursements notwithstanding). Unless a scheme is hedged, this would represent a significant cost to its funding level.
Up to now, LDI strategies have mostly been assessed against a backdrop of declining, not static, interest rates. Given this, it is not surprising that one of the most common push-backs on LDI as a strategy is a view that pension schemes should wait for rates to return to higher levels before hedging. Interest rates will eventually rise, but the 2.5% in annual carry cost, aka potential funding level erosion, is a very expensive price to pay for the privilege of waiting.
John TownerDirector, Investment Consulting
STEP 52
O U T L I N E March 2013
Estimating The Equity Risk Premium
The last ten years have not gone quite the way most textbooks said they should have. Indeed, anyone estimating the equity risk “premium” based on the last ten years would have to conclude that it was sizeably negative, around -3 percentage points.
But in reality, the whole idea of the risk premium is that it is uncertain. It’s the concept of chasing the two in the bush instead of the one bird in the hand. But, clearly, sometimes that risk doesn’t pay off; the historical, realised risk premium should fluctuate wildly and sometimes be negative even over long periods.
What is indisputable is that over the very long term – 100 years, say – equities have spectacularly outperformed bonds. Between 1900 and 2011, the UK was hit by the Great Depression, nearly bankrupted by two world wars, lost the Empire, and was then again struck by the recent recession; yet according to the Barclays Equity-Gilt Study 2012 focusing on that period, the equity markets still showed a realised inflation-adjusted risk reward of 300bps. For the US, from 1926, the figure was 4.54%.
However, using simple historical data to estimate the equity risk premium has two serious drawbacks. The first is that it depends enormously on which time period one chooses. Even over long periods (10+ years), there is substantial variation:
The reason for this substantial variation is the domination of a few extreme results within the equity return data. So five good years and one bad day can create a bad five years of returns. To put this in context, Professor Javier Estrada from IESE Business School finds that “Outliers have a massive impact on long-term performance. On average across all 15 markets [considered], missing the best 10 days resulted in portfolios 50.8% less valuable than a passive investment; and avoiding the worst 10 days resulted in portfolios 150.4% more valuable”.
The second problem is that using historical data means that any estimate of the equity risk premium would be highest just before a market crash, and lowest before a rally. If one were to use the estimate to make investment decisions, the investor would be underweight for all the good days and overweight for all the bad days, losing a lot of money as a result.
In the long term, equities seem likely to outperform bonds. As an investor, one may well feel they are worth the risk. But to any individual or pension fund dependent on earning that premium, the question becomes: “how reliant can you afford to be on an estimate that you expect to be highly uncertain?” And, “is there a way I can earn these returns in a more reliable way?”
Alexander WhiteAnalyst, ALM & Investment Strategy
Source: Data, http://www.econ.yale.edu/~shiller/; Calculations, Redington
Frequency of 10 Year Rolling Annualized Returns of US equities from 1871
STEP 6O U T L I N E March 20133
Equity Replacement Strategies
Estimates of the Equity Risk Premium (“ERP”) vary from gilts +3% to 5%. Can this be achieved using other asset classes?
ERP estimates depend on whom – and when – you ask. Many studies produced over the last few years highlight the equity market’s failure to deliver its expected ERP. Evidence also shows how excluding the best or worst months can have a dramatic impact on returns.
Most pension funds rely on equities as the biggest contributor to expected return – the risk contribution is even greater.
Hence, increasingly trustees are asking: “What is the equity risk premium?”, “Can I rely on it?”, and “Can I earn it more reliably?”
We believe alternative assets can be found that can deliver equity-like expected returns more reliably, with no more risk. A classic opportunity arose in Q408/Q109 when investment grade credit spreads ballooned such that credit offered ERP-like expected returns. However, credit spreads have tightened such that, today, it is doubtful if even high yield bonds could offer gilts +3% (net of conservative expected default losses).
What opportunities are available today? It turns out that there are many: starting with High Yield and Leveraged Loans, spread tightening means that – net of (conservative) expected losses – HY cannot match a 3% ERP. Due to markedly superior recovery rates in default, leveraged loans remain a candidate.
At first sight, a conservative trustee might baulk at the idea of a sub-investment grade loan; however, analysis shows that the risk-adjusted expected return is attractive relative to equities.
Moving down in liquidity, we find senior, secured lending opportunities where banks have been forced out of the market due to increased capital requirements (Basel III) and balance sheet costs. Specifically, commercial real estate lending and SME lending can conservatively match the 3% to 5% ERP.
Credit markets remain severely impacted by the financial crisis and ongoing bank balance sheet deleveraging and, in skilled hands, the resulting dislocations can be “harvested”. The best long/short credit managers have demonstrated their ability to earn ERP-like returns with a fraction of the equity market volatility.
Nearly all of the opportunities highlighted above have investment horizons of 3 to 7 years, whereas the ERP is typically assumed to be earned over horizons of at least 10 years. Pension schemes typically have an even longer investment horizon; does this raise any issues?
Considering the importance of entry levels to ex-post ERPs, if you believe that you can “call” the equity market and get the right entry levels, then this could be an issue.
However, given the massive impact of “outlying” days (i.e. the best and worst) and the difficulty of calling entry levels, we believe that diversifying into assets that offer a more reliable ERP-like return over a shorter horizon – irrespective of timing of entry level – can benefit many pension scheme portfolios.
David BennettManaging Director, Investment Consulting
STEP 7O U T L I N E March 20133
Risk Parity Rationale
Attractive alternatives to capital-based allocations are gaining traction. Risk Parity offers one risk-controlled route for investors.
Traditionally, investors have allocated assets based on capital values: 50% of a portfolio may be in equities, 30% of it in bonds and 20% in other asset classes including alternatives. While this seems to be a diversified portfolio, it is startlingly undiversified when viewed through the lens of risk. An average UK pension fund holding 44% of its assets in equities has portfolio risk overwhelmingly stemming from equities: c.87% of total risk.
This imbalance is not healthy; the portfolio becomes beholden to the performance of equities. Using 40 years of data, for a portfolio consisting of 60% equities and 40% bonds, the correlation of yearly returns between the equity component and the overall portfolio is 95%. For this reason, traditional balanced portfolios suffered large drawdowns during the financial crisis mirroring the performance of equities.
Risk Parity – A SolutionRisk Parity strategies have gained prominence due to their superior long-term risk-adjusted performance, weathering the financial crisis better than traditional portfolios. Their aim is to balance risk evenly across asset classes (most commonly across equities, bonds and commodities). This allows Risk Parity-based portfolios to perform in a variety of environments, and not just those in which equities perform well.
As the risk levels of different asset classes
change, Risk Parity strategies reweight to maintain
the overall balance.
The benefits to allocating by risk rather than by
capital value are plain. Risk Parity strategies
are more consistent performers as economic
conditions change – the aim of true diversification.
During the high inflation period of the ‘70s, when
equities and bonds both performed poorly, it was
a Risk Parity strategy’s exposure to commodities
that bolstered return while a traditional balanced
portfolio would have foundered.
A feature of many Risk Parity strategies is the use
of leverage to increase risk to a level comparable
to that of a traditional balanced portfolio (a
volatility of about 10%). If a Risk Parity strategy
did not use leverage, the overall risk would usually
be too low for most investors, resulting in returns
below those required. In fact, investor aversion to
leverage may be one of the key reasons for Risk
Parity outperformance. As many investors hesitate
to use leverage, they typically overweight higher-
risk assets, such as equities, in order to achieve
target returns. This leaves lower risk assets
relatively undervalued and may explain why low
volatility assets have tended to outperform high
volatility assets over the long-term. Risk Parity
strategies overweight these undervalued assets,
providing a possible pathway towards sustainable,
higher risk-adjusted returns (higher Sharpe ratios).
In an increasingly risk-focused world, Risk Parity
strategies represent a powerful way for pension
funds to achieve their funding goals with minimum
risk.
Aniket DasAssociate, Manager Research Team
STEP 8O U T L I N E March 20133
The deleveraging of banks has created an attractive opportunity in the Commercial Real Estate Debt space.
The media hype surrounding bank deleveraging is unlikely to subdue in the near future as Basel III, a regulation which places a number of significant constraints on banks’ activity, is just round the corner; it is scheduled to be introduced gradually over the next six years. The new law focuses on three main areas: introducing a minimum liquidity standard, limiting leverage, and increasing the level of existing required capital buffers. Given these more stringent rules, particularly around minimum capital requirements, capital-intensive assets like Commercial Real Estate Debt (CRE Debt) are likely to shift towards non-bank capital, particularly insurance companies and defined benefit pension funds.
What is CRE Debt?CRE Debt consists of fairly illiquid, usually floating rate loans backed by commercial real estate, such as offices, retail, hotels, etc. The average term is 5 years and there are commonly penalties on prepayment. In the past, investors accessed some CRE Debt via their investment in Commercial Mortgage Backed Securities. Nowadays however, due to regulation and lack of buyer appetite, this market has dried up.
The OpportunityAt the end of 2010, outstanding European debt secured by commercial property and due to mature in the following ten years amounted to €960bn, according to CBRE. Around 75% of this is held on banks’ balance sheets, and just over 40% matures in the three year period between 2013 and 2015 (inclusive). Given the reluctance of banks to offer refinancing, particularly at more elevated loan-to-value (LTV) ratios, the borrowers are likely to face a significant funding gap.
As a result of this gap, two key positive shifts in the CRE lending market have occurred: first, the typical LTV levels of the senior debt portion have fallen dramatically, from 75 to 80% all the way down to 50% to 60%. Second, at the same time, the lending spread being charged on this senior debt has widened from approximately LIBOR + 50-80 bps to a range of 300-450 bps over LIBOR.
Before 2007, such levels were hardly attainable even on mezzanine finance. See diagram below.
These two changes have driven a significant improvement in the overall risk-adjusted return available to lenders at the senior debt level. On top of all this, significant falls in real estate capital values have already occurred over the past few years, lending covenants have been strengthened significantly, and additional equity contributions from real estate owners have increased. Investors enjoy another layer of security, too, stemming from the location of underlying property. About half of the outstanding European CRE debt is secured against real estate in core countries such as UK and Germany.
We believe that pension funds and other institutional investors such as insurance companies are in a good position to exploit this opportunity, reaping attractive risk-adjusted returns by providing the necessary finance.
Kate MijakowskaAnalyst, Manager Research Team
Source: M&G
Commercial Real Estate Debt
Typical Capital Structure 2007 Origination
Equity
5 -15 %
Mezzanine / B-note
Senior loan / A-note
LIBOR + 200-300 bps
LIBOR + 50 - 80bps75-80%
2007
Typical Capital Structure 2010 Origination
Equity
Fall in property values
-13.4% (vs 2007)
15 - 20 %
5 - 15 %
5 - 15 %
20-25 %
Mezzanine / B-note LIBOR + 700-1200 bps
Senior loan / A-note LIBOR + 200 - 250bps60-65%
2010
Typical Capital Structure 2012 Origination
Fall in property values
-11.8% (vs 2007)
Equity 20-30 %
Mezzanine / B-note LIBOR + 900-1300 bps
Senior loan / A-note
LIBOR + 500 - 800 bps Stretch - Senior
LIBOR + 300 - 450 bps50-60%
2012
5 - 15 %
STEP 9O U T L I N E March 20135
“Human beings can’t run a mile in under 4 minutes. It simply isn’t possible.” Sound ridiculous? It does now! But for a long time it was the consensus.
A mental model: an assumption about how the world worked.
A sub-four minute mile seemed like a physical feat that humans could not break. But in 1954 Roger Bannister ran a mile in three minutes, fifty nine seconds and four milliseconds. Suddenly, in the following three years, sixteen other runners ran a mile in under four minutes.
Was there some breakthrough in human evolution? No. The mental model changed.
Could a similar mental model have affected the defined benefit pension industry? For decades, schemes focussed on assets and failed to pay adequate attention to liabilities. The consequences are still being felt today, with many schemes experiencing falls in funding levels as a result of lower interest rates and their impact on the value of liabilities. Pension scheme trustees now face increased complexity in an uncertain economic outlook, volatile market conditions and upcoming regulatory changes that have rendered returns uncertain too.
“Everything should be made as simple as possible, but not simpler”. Albert Einstein
Pension schemes can simply start the process of taking control by agreeing and writing clear goals and objectives. The document in which these are laid out then becomes the foundation for any funding, investment and risk management decisions and actions.
Clear goals and objectives allow the stakeholders to move away from a traditional asset-based framework to a risk-based asset and liability framework; all key factors are considered simultaneously and, vitally, all decisions are completely informed.
Once stakeholders have clear goals, monitoring how the scheme performs against those objectives is key to continually attaining success. Quality monitoring should not only feature visual and numerical analysis, but also explain in plain English what the analysis actually means so stakeholders can make informed decisions as a result.
Regular quality monitoring lets stakeholders fully understand the sources and drivers of risk and return by using critical components such as required return, funding level, liquidity and collateral requirements. By fully understanding these key drivers, stakeholders can assess investment opportunities within the goals and constraints of their particular fund, and assess the impact of expected returns versus required returns.
Alongside good governance, monitoring enables effective action by providing a clear framework within which to make decisions. It informs by highlighting the most relevant scheme metrics, and good monitoring reports provide obvious signposts for immediate action. Clear goals plus easy-to-understand monitoring forms a powerful blueprint for any investment committee, CIO or fiduciary manager to follow.
Unsurprisingly, pension schemes that have taken the time to agree their objectives and regularly use good monitoring and reporting tools have clearer accountability within their teams, and post better results. Decisions are taken in the context of agreed objectives, and are reassessed regularly to determine progress and be adjusted accordingly. With the right monitoring tool in place, schemes are smart, nimble and more successful.
Teresa NgoneVice President, Investment Consulting
Monitoring Progress On The Run
STEP 10O U T L I N E March 20137
Pension schemes are realising the unpredictability of financial markets and looking for ways to manage its volatility while meeting their return requirements. Is there a way out?
Here’s the story of a small pension scheme which has managed this exceedingly well by following a disciplined and robust approach, delivering an impressive performance as a result.
Turning back to the summer of 2008, the Scheme was close to being fully funded on a buyout basis, but still with over 90% of its assets invested in equities and less than 5% in bonds. By the time the trustees knew about the Scheme’s excellent position, it was too late. In September 2008, financial markets collapsed and the Scheme suffered a sharp deterioration in its funding position, so a buy-out was out of reach.
The trustees became determined to take control of the situation and set up a framework to ensure this didn’t happen to them again. The first step was to set clear and realistic funding and risk objectives for the Scheme, then using this, to design a simple yet efficient investment strategy to achieve those objectives. The trustees adopted the use of derivative instruments to achieve efficiency
and simultaneously put in place a dynamic de-risking programme to monitor the funding level on a daily basis. They would move from risky assets to matching assets as their funding level improved based on pre-set trigger and action points. They also had a plan to consider re-risking if things were to go bad.
The initial set-up required time and effort but the whole Trustee Board was more than willing to engage and work with the Sponsor and Investment Consultant to set up the framework and become comfortable with the dynamic process. Later, the de-risking programme was automated and outsourced to their LDI manager.
After one and a half years, the Scheme is now more than 10% better funded than if it had not implemented this approach, with a funding level which is fully protected against interest rate and inflation movements. It has also reduced its equity exposure from more than 90% to less than 10%. The conditions this Scheme faced are the same as any other. Some may say the Scheme had simply been lucky when making certain timely de-risking and re-risking decisions. Maybe that was the case; however, the decision to re-risk or de-risk was not based on “market sentiments” but a well-defined metric we call “required return to full funding”.
In recognition of its work, the Scheme has received three well-deserved pension awards during this period.
Neha BhargavaVice President, Investment Consulting
Dynamic Risk Management In Practice
De-Risking Triggers
De-Risking Trigger
Re-Risking and refresh of triggers Review investment Strategy
De-Risking Triggers
Re-Risking Triggers
STEP 11O U T L I N E March 20137654321
A Step Change in “Money Safe” Defined Contributions Saving
As traditional sponsor-backed final salary pension provision in the UK fades into the background, greater focus is being placed on Defined Contribution (“DC”) arrangements and how institutional investment strategies could be adapted to meet the needs of individual pension savers.
Historically, many DC schemes have adopted conventional approaches to asset allocation which feature substantial capital weighted allocations to equities. However, the volatility of equity markets in the last 15 years, driven by a series of substantial falls, has led to disappointing outcomes for members.
In order to help improve confidence in pensions saving, the Pensions Minister, Steve Webb, challenged the industry last year to think hard about the feasibility of providing “money safe” products.
We have been incorporating the latest thinking on rules-based risk control into our defined benefit clients’ investment strategies. Commonly known as Volatility Control, this approach systematically reduces exposure to markets as their daily volatility increases and raises exposure as the daily volatility falls.
In driving terms, it means easing your foot off the accelerator when the conditions you face get worse – rain, visibility, grip - and pressing down again as conditions improve.
Highly liquid and transparent, we believe this methodology has great application for DC and could be used to offer DC savers
both the potential for improved outcomes and the ability to provide such “money safe” protection on member savings pots, all in a cost efficient manner.
We believe this approach would offer three layers of risk protection for the member:
- Risk control at the individual asset class level.
- Risk control and diversification at the total portfolio level.
- Outright downside protection on the total portfolio.
By way of example, the graph below show the net of fees results of traditional DC approaches, standalone risk controlled approaches and a “money safe” risk controlled approach. These calculations are based on a simple model of DC investment savings over the 25 year period ending 31 December 2012, with regular monthly contributions starting at £150 per month, increasing steadily over time.
Patrick O’Sullivan FIA CFAVice President, Investment Consulting
Summary of outcomes for various DC approaches
12O U T L I N E March 2013STEP
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13O U T L I N E March 2013Further Information and Disclaimer